Capitalization rate (cap rate)

Capitalization rate, or cap rate, expresses how much income an investment property generates relative to its price, giving investors a quick way to compare properties or markets independent of financing structure. A lower cap rate generally signals a more expensive, often lower-risk property relative to its income; a higher cap rate signals cheaper pricing relative to income, which can mean either opportunity or higher risk.

The formula is cap rate = net operating income / current market value, where net operating income is rental income minus operating expenses, before financing costs and taxes. Because financing is excluded, cap rate isolates the property's own income performance from how a particular buyer chose to fund the purchase, which is what distinguishes it from levered return measures like internal rate of return that do account for debt and the timing of cash flows.

Cap rate depends directly on occupancy rate and achievable rents, and is often used alongside an automated valuation model or a full discounted cash flow analysis to sanity-check a property's asking price. A common pitfall is comparing cap rates across markets or property types without adjusting for risk and growth expectations: a low cap rate in a stable, high-demand market and the same low cap rate in a declining one imply very different things about future returns.